Dr Y V Reddy's recently concluded five-year term as the Governor of the Reserve Bank of India coincided with India's growth surge and its increasing global significance.
Not surprisingly, then, the period has also been one of very fundamental changes in the domestic macroeconomic environment. Dr Subbarao's assumption of office is an appropriate time to take stock of the how the previous regime dealt with them and what this means as far as what the priorities of the new regime should be.
The most immediate priority is, of course, the management of the business cycle, whose downturn phase the economy is clearly in right now. The dynamics of the cycle have become quite complicated with the inflationary pressures that became visible earlier this year.
When the RBI began to seriously clamp down on liquidity towards the end of 2006, the compulsions were quite different. The economy was seen to be overheating and, therefore, amenable to policy actions that would bring inflation under control by reining in inflation.
In fact, around the world, 2007 was supposed to see a peaking of the cycle and central banks were getting ready to move to a neutral stance, or even begin reducing policy rates, in 2008.
The massive rise in oil prices, accompanied by sharp increases in the prices of other commodities, changed that outlook rather abruptly. With the exception of the US, where the Federal Reserve had to cut rates sharply at the beginning of 2008, other central banks were compelled by the inflation surge to prolong the tightening phase of their interest rate cycles.
That compulsion has not abated as yet. Its impact on growth has become increasingly visible, even as the inflation rate remains uncomfortably, even dangerously, high. This rather undesirable combination of slowing growth and high inflation can be seen as a failure of the policy approach, inducing the new regime to change its stance.
There are significant lessons to draw from recent experience when making this decision. The ability of relatively small, calibrated policy measures to significantly influence demand and, consequently, GDP growth, has been amply demonstrated over the past year.
This attests to the efficiency of the mechanisms by which policy measures impact economic activity. The more efficient these mechanisms, the less drastic policy measures need to be and, consequently, the lower the risks of making the wrong moves.
The course of action that the RBI chose does have both an analytical underpinning and an unavoidable trajectory. The paradigm supporting the policy stance is, quite clearly, one that requires the central bank to keep its focus on the medium-term rate of inflation, not just the immediate.
This, in turn, requires a predictable policy response every time the inflation deviates from a benchmark - call it the target rate, the comfort zone, the neutral zone or whatever.
Failure to respond in the manner predicted will confuse investors and consumers, perhaps enough to influence their long-term decisions in ways that are adverse to the economy. On the other hand, making the predicted response will re-assure the same groups that the deviation is very likely to be temporary.
Predictability is the key word here. Having followed the monetary actions of the RBI relatively closely over the past five years, I saw improvements in the ability of people to forecast its policy actions.
While central bankers may derive some satisfaction in their ability to surprise markets and Dr Reddy was sometimes characterised by the media as one such, I think that, over the five years, the RBI's monetary policy announcements, with maybe a couple of recent exceptions, were both increasingly predictable and consistent with the behaviour of macroeconomic indicators.
This is where the trajectory comes into play. Once a course of action has been selected, even if one disagreed with it to begin with, changing course mid-stream can often do more damage than following the path to its logical conclusion.
From this perspective, Dr Subbarao's statement that he would put priority on anchoring inflationary expectations is significant. It can be interpreted as a signal that he will continue with the current stance, reversing the interest rate cycle when the inflation rate appears to be converging with the benchmark.
Let us turn to a second set of milestones, which were in sharp contrast to the predictability that I attributed to the monetary management regime. These are with respect to the exchange rate.
For the first three and a half years of Dr Reddy's term, the stance towards the rupee was one of robust resistance against the pressures of appreciation that resulted from India's emergence as an attractive investment destination.
Accumulating foreign exchange reserves and sterilising them to prevent an explosion of domestic liquidity was something that all our neighbourhood emerging economies did and that perhaps provided some justification for us doing the same thing.
Whether this was an efficient way of dealing with the situation, particularly when the drivers of growth were primarily domestic is a legitimate question.
However, that is in the past and we should focus on the developments during 2007 and 2008. First, with a significant reduction in intervention levels, the rupee appreciated sharply, evoking both howls of protest and cries of joy.
Then, just when it seemed to have stabilised, the impact of the global financial turbulence on capital flows into emerging markets caused the rupee to depreciate sharply. It is now lower than it was when the gyrations began last March.
The problem essentially is that the stated position of the RBI - that it manages volatility but not the level of the exchange rate - is at odds with what the markets believe that it does. Massive reserve accumulation and the movement of the rate within a narrow band for such a long period tell their own story as to what the actual policy position is.
If the movements of the past year and a half are to be interpreted as an abandonment of the previous regime, no one should have any problems with that, particularly now that the availability of currency futures provides a means to hedge against two-way price risks.
But, the most important requirement for a policy to be effective is that it needs to be clearly articulated. That, I believe, has not been done and it should be the priority of the new Governor to do it as soon as possible.
The writer is Chief Economist, Standard & Poor's Asia-Pacific. The views are personal
